David R. Henderson  

Barone on Personal Exemptions and Tax Credits

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An Exemption is not a Credit

A steeply progressive income tax combined with generous dependent deductions ($500 originally, later raised to $600) played some unquantifiable part in stimulating the Baby Boom and family stability for a generation after the war.

Lee proposes a $2,500 child tax credit -- less in real dollars than the postwar deduction -- applied to both payroll and income taxes.

Those statements from columnist Michael Barone are both correct. But if you don't think about them very carefully, you probably think that Barone is saying that the effect of the tax code in creating an incentive to have a kid is less now than it was in the years just after World War II. I think even Michael Barone thinks he's saying that.

But it's not true.

The reason is that the value to the taxpayer of a $2,500 tax credit is $2,500. The value to the taxpayer of an $X exemption is not $X but $X*t, where t is the marginal tax rate.

The postwar personal exemption from 1948 on was $600. The lowest marginal tax rate in 1948 was 20%. That makes the value of the exemption $600*0.2 = $120. Inflation adjust that to 2013 and the value is $1,162. So for people in the lowest brackets, the incentive to have a kid would be greater with a $2,500 credit than with the old $600 exemption.

Note: Barone addresses this issue in discussing Mike Lee's proposal for what I called an anti-supply-side tax cut.

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COMMENTS (5 to date)
Tracy W writes:

Stupid question time: why do you multiply an exemption by the marginal tax rate when calculating its value but not a tax credit?

BJ Terry writes:

Tracy, an exemption reduces the amount of your income which your taxes are calculated on (taxable income), while a credit reduces the amount you pay after multiplying by the tax rate. You can think of the formula as being: Amount Earned - (Taxable Income * Tax Rate) + Tax Credits = Amount Kept, where Taxable Income is: Amount Earned - Exemptions.

So if you were going to be taxed $2,000 on $10,000 of income (20%), a $600 exemption would mean the Taxable Income would instead be $9,400 (even though you made $10,000), and you would only pay $1,880 in taxes. Instead of keeping $8,000, you keep $8,120.

A tax credit just reduces the taxes you pay after they are already calculated using the tax rate. So if you received a $600 credit, you would calculate the $2,000 (20%), but then only have to pay $1,400 in taxes, leaving you with $8,600 kept.

MingoV writes:

The child tax exemption is so small compared to the costs of raising a child that it is not an incentive for child-rearing. I never met anyone who raised a child to reduce income taxes. The only people I know who had children for financial purposes were single mothers on welfare who received additional benefits with each child. Those benefits added far more (proportionally) to a welfare parent's income than a federal income tax child exemption did for a family at any income level.

David R. Henderson writes:

I never met anyone who raised a child to reduce income taxes.
Nor have I. I do think that people respond to incentives. The tax break alone is well below the cost of raising a kid. But for someone on the margin, it could make a difference. And if it did, the person who was affected could honestly say he didn’t raise a child to reduce his taxes. Instead, he would say that he raised a child because he wanted a child and the fact that he got a tax break helped.
Think on the margin.

James writes:

The bigger problem with Barone's idea is that it follows the theme of trying to correct a problem where the state is at least partly to blame, without first eliminating the policies that are contributing to the problem.

A tax credit wouldn't do nearly as much for family stability as ending policies like locking up people's family members for victimless crimes, sending people's family members to remote locations to fight a never ending war on terror, providing lousy high schools that make high paying employment out of reach for those who cannot devote years to college, etc.

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